The emergence of direct lending as an asset classThe emergence of direct lending as an asset class

February 2015February 2015

Since the height of the 2008 financial crisis, retrenchment by banks from commercial lending has opened up the field for institutional investors to participate in lending to corporates and to infrastructure and commercial real estate projects. Mid-sized companies in particular welcome this alternative source of funding, given that they are generally too small to access the corporate bond markets.

Specialist alternative assets data provider Preqin estimates that the global direct lending market amounted to $96.6bn in assets under management as of June 2014. The company's research indicates that 43 direct lending funds closed in 2014, raising $25.7bn in the year. Looking ahead to what might be achieved in 2015, there are currently 72 direct lending funds in market, seeking an aggregate $43.1bn.

A clear trend is emerging, with something of a shift in middle-market borrowing from banks to the direct lending market. This is driven by three key factors.

Banks' appetite for lending is remaining subdued in the face of increased capital requirements and competition for allocation of available capital.

Borrowers are becoming increasingly attracted to the market because it introduces multiple routes to finance. Direct lending offers term, brings competition to the banking sector and is not complicated by the typical banking practice of seeking further business, such as credit cards, company car schemes and clearing.

Institutional investors are beginning to adopt direct lending as an asset class, being attracted to good risk-adjusted rates of return.

"In a world where you have the 10-Year U.S. Treasury Bond yield hovering around 2%, increased volatility and narrowing spreads in the high-yield market, and wide swings in the public equity markets, we believe that the direct lending asset class looks very attractive," says Michael Dennis, managing director at direct lender Ares Capital Europe. "Direct lending returns generally have low volatility, which is also attractive relative to other debt and equity asset classes. In fact, recently, we have started to see examples of investors turning away from the volatile bond markets in favour of our commingled and separately managed accounts, and we believe this to be a long-term trend – the inclusion of [direct lending] in traditional fixed income portfolios."

Research conducted by Prequin reveals that more than 1,000 institutional investors worldwide have dedicated investment plans or commitments to private debt, which it expects will increase significantly over the coming years. The company currently monitors almost 700 managers worldwide which have raised in excess of 1,500 private debt vehicles historically, including direct lending, mezzanine finance, distressed debt, special situations and venture debt funds. It calculates that private debt funds have generally been providing investors with net returns in excess of 10% per annum on average, with funds of vintage 2009 producing returns of 17% on average.

Borrower case study

Hall & Woodhouse (H&W) is a family-owned brewer and pub operator, headquartered in Dorset, England. Founded in 1777, it is best-known among British ale enthusiasts for its Badger brand. The company acquired the brewer King & Barnes in 2000 and has ambitious plans to continue growing.

Before the financial crisis, H&W had concentrated approximately 75% of its borrowing needs with a single bank, The Royal Bank of Scotland, which had driven up its market share through the use of aggressive pricing. Post-crisis, the Bank began encouraging the company to take its business elsewhere. It has done just that, initially turning to Barclays, HSBC and Lloyds Bank. During the term of a club-funding facility from these lenders, the brewer wanted to go to market for alternative funding sources and turned to Deloitte, who identified insurance companies as a source of business funding. After surveying the market, H&W decided to invite M&G Investments, one of the UK's longest-established asset managers and part of Prudential plc, to provide a refinancing package.

H&W has borrowed a total of £20 million from M&G in two tranches, one with a nine-year tenor and the other 10 years. This investment came from the ‘M&G UK Companies Financing Fund 2', a £500 million fund launched in 2012, specifically to offer corporate loans to mid-sized companies. It is backed by the UK Government's Business Finance Partnership, together with Prudential and a number of UK pension funds.

"We're paying slightly more than we would to a clearing bank," explains finance director Martin Scott, "but it is for 10-year money compared with the maximum of five years we might have achieved [elsewhere], and we will accept a certain cost to our profit and loss account to reduce risk."

Since striking up the relationship with M&G as a prime lender, H&W has seen a remarkable transformation in its traditional banking relationships. Faced with a new competitor disrupting their business, banks have been "incredibly flexible" in discussions with him, Mr Scott says, offering improved rates and longer maturities than had previously been the case.

The institutional investor's perspective

James Pearce, head of direct lending at M&G Investments, is notably optimistic about the prospects for direct lending in the short- to medium-term. On the supply side, he points to the fund-raising activity of the past two years serving to build up a head of steam, while disintermediating the banks to an extent. On the demand side, he notes that many companies have realized that bank funding which was relatively simple to access is not always so easy to obtain. "Having multiple routes to finance is a good idea for the modern finance director," he suggests. Looking at the broader macroeconomic scene, he sees a likely pick-up in mergers and acquisitions activity as western economies begin to grow again.

An executive at a private equity house, who asked not to be identified, goes so far as to say that 2015 will be a 'bumper' year. The direct lending market will reach critical mass in terms of funds raised, he forecasts, adding: "We have the best pipeline of deals since we initiated our direct lending strategy. We have never been busier and are inundated with applications. Our biggest risk is not origination, it is credit selection. The real challenge is making sure we do the right deals. For that, a good team capable of doing effective due diligence in a timely and thorough manner is essential."

For Neale Broadhead, a managing partner and portfolio manager at private equity and advisory firm CVC Capital Partners, further development of direct lending will take place as potential borrowers become more educated about its possibilities in an ever-changing financial landscape. "We will benefit as companies learn more about what we can do. Banks have been impacted by the recent European stress tests and asset quality review; they have their own capital problems and this has created a gap that someone has to fill. As banks do less, we can help businesses grow; we have patient and flexible capital," he says. "As our capital is non-amortising, cash generated by a business can be ploughed straight back into that business. We are more flexible on structures and covenants, and look at each proposed deal in a bespoke manner."

The global direct lending market amounted to $96.6bn in assets under management as of June 2014. More than 1,000 institutional investors worldwide have dedicated investment plans or commitments to private debt.Research from Prequin

Mark Brenke, London-based managing director at Ardian (formerly AXA Private Equity) believes the European direct lending market, and the wider leveraged loan market, will continue to grow steadily as direct lending continues maturing into an established asset class. "Three years ago, you may have asked ‘how sustainable is it?' You might have thought it a blip, but today direct lending is firmly established as a financial product in the marketplace, especially in situations that require a bespoke financial solution. Growth companies need flexible growth capital for organic growth and growth by acquisition. They need financing that goes beyond traditional bank parameters."

David Brookes, an executive vice president at credit specialist Sankaty Advisors, a Bain Capital affiliate, is another who predicts ongoing growth in direct lending for a number of reasons. "Firstly, we see increasing acceptance of the value that direct lending brings from borrowers, sponsors and advisers," he says. "Secondly, bank appetite for certain forms of lending remains constrained. Thirdly, we see the mergers and acquisitions market delivering a higher volume of new transactions, not least because of the amount of dry powder that private equity firms have available to invest in equity and the fact that the private equity industry is also sitting on a backlog of companies that must be sold or refinanced and this too will help drive the direct lending side of the market forward."

On the other hand, Andrew McCallagh, head of origination at HayFin Capital Management, believes that the incidence of new M&A transactions will be relatively subdued, limiting the universe of new lending opportunities. In such a scenario, firms with an established origination footprint will have an inherent advantage. Newer arrivals in the space will struggle to gain access to deal flows, he says. Their eagerness to build a book of business could push them into accepting tighter spreads than the underlying risks merit, storing up future potential problems. His firm's overall expectation is that the direct lending market will go from strength to strength.

We have seen significant deal volumes now from our French business over the past two years, and Germany and the Nordics continue to see greater activity levels year-over-year.Michael Dennis, Ares Capital Europe

The pressure on investors to access yield in an extended ultra-low interest rate environment will also play a significant role. For the institutional investor, a crucial initial question is their willingness to assume additional credit risk in the pursuit of higher yield. An equally important follow-up question is whether the degree of additional risk incurred is appropriately remunerated. Determining the right price that should be paid to investors in a relatively new market is far from straightforward, not least because of the difficulty in distinguishing between the underlying driving forces. Is an investor being paid a premium for illiquidity or for higher risk? Given the limited amount of information on default rates in this nascent market, it is too early to make a definitive judgment call.

There clearly exists a growing opportunity for non-bank lenders to take an even greater share of the market as banks continue to retrench and face new regulation that discourages them from making corporate middle-market loans. "This fundamental macro-trend has caused the direct lending market to become more competitive," says Michael Dennis at specialist middle-market lender Ares Capital. However, it also requires that managers of direct lending funds maintain their lending discipline both in credit selection and in seeking compelling risk-adjusted returns for investors, in order to ensure their longevity in the alternative debt asset class in Europe. Flexibility and speed are of little benefit if wrong decisions are made.

"We are confident of our investment discipline," says Mr Dennis. "It has been tested through several market cycles, and we are established participants in this market for the long haul. Others, as we have seen, view direct lending as a trade or a one-off opportunity, and they may face more headwinds with this increase in competition." On opportunities for growth, he interprets Deloitte's recent figures on alternative lender middle-market deal flow for the UK and Continental Europe as suggesting that there is an even greater untapped opportunity for alternative lenders in Europe.

We have the best pipeline of deals since we initiated our direct lending strategy. Our biggest risk is not origination, it is credit selection.

While borrowers in continental Europe have been a little slower to adopt financing solutions from alternative lenders than those in the UK, this trend is starting to change, Mr Dennis goes on to observe. "We have seen significant deal volumes now from our French business over the past two years, and Germany and the Nordics continue to see greater activity levels year-over-year. The relative health of German and Nordic banks has certainly impacted the adoption of non-bank financing, but we are seeing borrowers start to understand the benefits of alternative financing solutions - one-stop financings and certainty of closing since we hold most deals and do not syndicate them - and Ares is gaining greater traction in these geographies."

Despite the tailwinds gathering behind direct lending, it will be of some comfort to bankers that they will not be frozen out. Direct lenders readily accept that the different fields of activity in which their quite different institutions work are complementary rather than mutually exclusive.

Says Mr Brenke: "Private debt does not require banks to suddenly disappear. Some companies will need more bespoke financial solutions than others. Established companies with established cash flows are more suitable for traditional bank financing and we will in any event include banks in the loop to provide revolving credit and to meet the demand for ancillary services such as cash management: the kind of additional business that banks like doing because it has a low capital cost."

The steady rise of direct lending has prompted some banks to become more flexible in the lending structures they offer. Even with such responses from the banks, alternative lending is expected to grow at a healthy rate and become an accepted asset class for institutional investors.

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Since the height of the 2008 financial crisis, retrenchment by banks from commercial lending has opened up the field for institutional investors to participate in lending to corporates and to infrastructure and commercial real estate projects. Mid-sized companies in particular welcome this alternative source of funding, given that they are generally too small to access the corporate bond markets.

Specialist alternative assets data provider Preqin estimates that the global direct lending market amounted to $96.6bn in assets under management as of June 2014. The company's research indicates that 43 direct lending funds closed in 2014, raising $25.7bn in the year. Looking ahead to what might be achieved in 2015, there are currently 72 direct lending funds in market, seeking an aggregate $43.1bn.

A clear trend is emerging, with something of a shift in middle-market borrowing from banks to the direct lending market. This is driven by three key factors.

Banks' appetite for lending is remaining subdued in the face of increased capital requirements and competition for allocation of available capital.

Borrowers are becoming increasingly attracted to the market because it introduces multiple routes to finance. Direct lending offers term, brings competition to the banking sector and is not complicated by the typical banking practice of seeking further business, such as credit cards, company car schemes and clearing.

Institutional investors are beginning to adopt direct lending as an asset class, being attracted to good risk-adjusted rates of return.

"In a world where you have the 10-Year U.S. Treasury Bond yield hovering around 2%, increased volatility and narrowing spreads in the high-yield market, and wide swings in the public equity markets, we believe that the direct lending asset class looks very attractive," says Michael Dennis, managing director at direct lender Ares Capital Europe. "Direct lending returns generally have low volatility, which is also attractive relative to other debt and equity asset classes. In fact, recently, we have started to see examples of investors turning away from the volatile bond markets in favour of our commingled and separately managed accounts, and we believe this to be a long-term trend – the inclusion of [direct lending] in traditional fixed income portfolios."

Research conducted by Prequin reveals that more than 1,000 institutional investors worldwide have dedicated investment plans or commitments to private debt, which it expects will increase significantly over the coming years. The company currently monitors almost 700 managers worldwide which have raised in excess of 1,500 private debt vehicles historically, including direct lending, mezzanine finance, distressed debt, special situations and venture debt funds. It calculates that private debt funds have generally been providing investors with net returns in excess of 10% per annum on average, with funds of vintage 2009 producing returns of 17% on average.

Borrower case study

Hall & Woodhouse (H&W) is a family-owned brewer and pub operator, headquartered in Dorset, England. Founded in 1777, it is best-known among British ale enthusiasts for its Badger brand. The company acquired the brewer King & Barnes in 2000 and has ambitious plans to continue growing.

Before the financial crisis, H&W had concentrated approximately 75% of its borrowing needs with a single bank, The Royal Bank of Scotland, which had driven up its market share through the use of aggressive pricing. Post-crisis, the Bank began encouraging the company to take its business elsewhere. It has done just that, initially turning to Barclays, HSBC and Lloyds Bank. During the term of a club-funding facility from these lenders, the brewer wanted to go to market for alternative funding sources and turned to Deloitte, who identified insurance companies as a source of business funding. After surveying the market, H&W decided to invite M&G Investments, one of the UK's longest-established asset managers and part of Prudential plc, to provide a refinancing package.

H&W has borrowed a total of £20 million from M&G in two tranches, one with a nine-year tenor and the other 10 years. This investment came from the ‘M&G UK Companies Financing Fund 2', a £500 million fund launched in 2012, specifically to offer corporate loans to mid-sized companies. It is backed by the UK Government's Business Finance Partnership, together with Prudential and a number of UK pension funds.

"We're paying slightly more than we would to a clearing bank," explains finance director Martin Scott, "but it is for 10-year money compared with the maximum of five years we might have achieved [elsewhere], and we will accept a certain cost to our profit and loss account to reduce risk."

Since striking up the relationship with M&G as a prime lender, H&W has seen a remarkable transformation in its traditional banking relationships. Faced with a new competitor disrupting their business, banks have been "incredibly flexible" in discussions with him, Mr Scott says, offering improved rates and longer maturities than had previously been the case.

The institutional investor's perspective

James Pearce, head of direct lending at M&G Investments, is notably optimistic about the prospects for direct lending in the short- to medium-term. On the supply side, he points to the fund-raising activity of the past two years serving to build up a head of steam, while disintermediating the banks to an extent. On the demand side, he notes that many companies have realized that bank funding which was relatively simple to access is not always so easy to obtain. "Having multiple routes to finance is a good idea for the modern finance director," he suggests. Looking at the broader macroeconomic scene, he sees a likely pick-up in mergers and acquisitions activity as western economies begin to grow again.

An executive at a private equity house, who asked not to be identified, goes so far as to say that 2015 will be a 'bumper' year. The direct lending market will reach critical mass in terms of funds raised, he forecasts, adding: "We have the best pipeline of deals since we initiated our direct lending strategy. We have never been busier and are inundated with applications. Our biggest risk is not origination, it is credit selection. The real challenge is making sure we do the right deals. For that, a good team capable of doing effective due diligence in a timely and thorough manner is essential."

For Neale Broadhead, a managing partner and portfolio manager at private equity and advisory firm CVC Capital Partners, further development of direct lending will take place as potential borrowers become more educated about its possibilities in an ever-changing financial landscape. "We will benefit as companies learn more about what we can do. Banks have been impacted by the recent European stress tests and asset quality review; they have their own capital problems and this has created a gap that someone has to fill. As banks do less, we can help businesses grow; we have patient and flexible capital," he says. "As our capital is non-amortising, cash generated by a business can be ploughed straight back into that business. We are more flexible on structures and covenants, and look at each proposed deal in a bespoke manner."

The global direct lending market amounted to $96.6bn in assets under management as of June 2014. More than 1,000 institutional investors worldwide have dedicated investment plans or commitments to private debt.Research from Prequin

Mark Brenke, London-based managing director at Ardian (formerly AXA Private Equity) believes the European direct lending market, and the wider leveraged loan market, will continue to grow steadily as direct lending continues maturing into an established asset class. "Three years ago, you may have asked ‘how sustainable is it?' You might have thought it a blip, but today direct lending is firmly established as a financial product in the marketplace, especially in situations that require a bespoke financial solution. Growth companies need flexible growth capital for organic growth and growth by acquisition. They need financing that goes beyond traditional bank parameters."

David Brookes, an executive vice president at credit specialist Sankaty Advisors, a Bain Capital affiliate, is another who predicts ongoing growth in direct lending for a number of reasons. "Firstly, we see increasing acceptance of the value that direct lending brings from borrowers, sponsors and advisers," he says. "Secondly, bank appetite for certain forms of lending remains constrained. Thirdly, we see the mergers and acquisitions market delivering a higher volume of new transactions, not least because of the amount of dry powder that private equity firms have available to invest in equity and the fact that the private equity industry is also sitting on a backlog of companies that must be sold or refinanced and this too will help drive the direct lending side of the market forward."

On the other hand, Andrew McCallagh, head of origination at HayFin Capital Management, believes that the incidence of new M&A transactions will be relatively subdued, limiting the universe of new lending opportunities. In such a scenario, firms with an established origination footprint will have an inherent advantage. Newer arrivals in the space will struggle to gain access to deal flows, he says. Their eagerness to build a book of business could push them into accepting tighter spreads than the underlying risks merit, storing up future potential problems. His firm's overall expectation is that the direct lending market will go from strength to strength.

We have seen significant deal volumes now from our French business over the past two years, and Germany and the Nordics continue to see greater activity levels year-over-year.Michael Dennis, Ares Capital Europe

The pressure on investors to access yield in an extended ultra-low interest rate environment will also play a significant role. For the institutional investor, a crucial initial question is their willingness to assume additional credit risk in the pursuit of higher yield. An equally important follow-up question is whether the degree of additional risk incurred is appropriately remunerated. Determining the right price that should be paid to investors in a relatively new market is far from straightforward, not least because of the difficulty in distinguishing between the underlying driving forces. Is an investor being paid a premium for illiquidity or for higher risk? Given the limited amount of information on default rates in this nascent market, it is too early to make a definitive judgment call.

There clearly exists a growing opportunity for non-bank lenders to take an even greater share of the market as banks continue to retrench and face new regulation that discourages them from making corporate middle-market loans. "This fundamental macro-trend has caused the direct lending market to become more competitive," says Michael Dennis at specialist middle-market lender Ares Capital. However, it also requires that managers of direct lending funds maintain their lending discipline both in credit selection and in seeking compelling risk-adjusted returns for investors, in order to ensure their longevity in the alternative debt asset class in Europe. Flexibility and speed are of little benefit if wrong decisions are made.

"We are confident of our investment discipline," says Mr Dennis. "It has been tested through several market cycles, and we are established participants in this market for the long haul. Others, as we have seen, view direct lending as a trade or a one-off opportunity, and they may face more headwinds with this increase in competition." On opportunities for growth, he interprets Deloitte's recent figures on alternative lender middle-market deal flow for the UK and Continental Europe as suggesting that there is an even greater untapped opportunity for alternative lenders in Europe.

We have the best pipeline of deals since we initiated our direct lending strategy. Our biggest risk is not origination, it is credit selection.

While borrowers in continental Europe have been a little slower to adopt financing solutions from alternative lenders than those in the UK, this trend is starting to change, Mr Dennis goes on to observe. "We have seen significant deal volumes now from our French business over the past two years, and Germany and the Nordics continue to see greater activity levels year-over-year. The relative health of German and Nordic banks has certainly impacted the adoption of non-bank financing, but we are seeing borrowers start to understand the benefits of alternative financing solutions - one-stop financings and certainty of closing since we hold most deals and do not syndicate them - and Ares is gaining greater traction in these geographies."

Despite the tailwinds gathering behind direct lending, it will be of some comfort to bankers that they will not be frozen out. Direct lenders readily accept that the different fields of activity in which their quite different institutions work are complementary rather than mutually exclusive.

Says Mr Brenke: "Private debt does not require banks to suddenly disappear. Some companies will need more bespoke financial solutions than others. Established companies with established cash flows are more suitable for traditional bank financing and we will in any event include banks in the loop to provide revolving credit and to meet the demand for ancillary services such as cash management: the kind of additional business that banks like doing because it has a low capital cost."

The steady rise of direct lending has prompted some banks to become more flexible in the lending structures they offer. Even with such responses from the banks, alternative lending is expected to grow at a healthy rate and become an accepted asset class for institutional investors.